A federal appeals court last week gave the Securities and Exchange Commission broad power under The Sarbanes-Oxley Act of 2002 to freeze “extraordinary payments” to company officers that are made when the Commission is investigating possible wrongdoing.
A three-judge panel of the San Francisco-based 9th Circuit Court of Appeals initially held in May 2004 that the SEC did not have the power under SOX to block $37.6 million in severance payments to the former chief executive officer and chief financial officer of Gemstar-TV Guide International.
But the full court upheld the Commission’s powers March 22, becoming the first federal appellate court in the nation to examine what constitutes “extraordinary payments” within the SEC’s reach under SOX. The court refused to set a bright-line test for determining when a payment is “extraordinary,” but said that proper considerations included whether the payment was connected to the suspected wrongdoing and whether it deviated from an “industry standard.”
“Wisely, we believe, both Congress and the SEC have avoided creating a specific litmus test that determines what is or is not an ‘extraordinary payment.’ To do so for all possible situations would be next to impossible and would serve only to guide corporate scoundrels searching for ways to circumvent this salutary law,” the court said.
Richard Humes, associate general counsel for the SEC in Washington, told Compliance Week that the 9th Circuit’s ruling “puts teeth” into section 1103 of Sarbanes-Oxley, the provision which gives the Commission the power to freeze extraordinary payments. “There shouldn’t be one formula for determining whether a payment was extraordinary. Instead, you should look at the size, the purpose and the circumstances under which the proposed payment was being made,” said Humes, who handled the 9th Circuit case for the Commission.
Cox
James Cox, a securities law professor at Duke University, called the 9th Circuit’s ruling “a terrific shot in the arm for the SEC.” In enacting SOX, Congress was “trying to give the SEC a wider range of sanctions to responsibly protect the public interest,” said Cox. “It intended to arm the SEC with a pretty strong remedy so that those assets would be available to investors and others at the end of the day. [Lawmakers] didn’t want to hamstring the SEC and thought the Commission would be a responsible actor,” Cox said.
Deal Cut As Company Unravels
The trouble for Gemstar, which publishes TV Guide and licenses technology for on-screen program guides, began on April 1, 2002, when the company filed its Form 10-K report for 2001. The filing reported that $107.6 million Gemstar had previously claimed as revenue had not actually been realized.
A few months later, Gemstar announced in an 8-K that it intended to restate its 2001 financial results and to reverse $20 million, plus make substantial corrections. Gemstar filed as exhibits to that Form 8-K sworn statements from CEO Henry Yuen and CFO Elsie Leung, to the effect that they were not able to certify, as required by law, that some of Gemstar’s financial statements were accurate, and that they were not able to comply with written Commission orders to do so.
A month-and-a-half later, Gemstar filed another 8-K, confirming that it had been notified by NASDAQ that its securities were subject to delisting for failure timely to file
a Form 10-Q for the quarter ending on June 30, 2002. The 8-K also stated that—because of an unresolved dispute between Gemstar and its independent auditor, KPMG—the company could not file its quarterly Form 10-Q report. KPMG itself was hit with a $10 million fine last November by the SEC for ignoring improper revenue statements from Gemstar.
As Gemstar was unraveling, Yuen and Leung cut a deal with the board of directors to resign as officers in return for a payment in cash. Yuen was to get $29.5 million and Leung $8.2 million, plus large shares of stock and options grants for both. After learning of the severance deal, the Commission commenced an investigation to determine whether Gemstar and its officers and directors had engaged in securities fraud by making materially false and misleading public statements regarding revenue, earnings and losses.
As part of the investigation, the Commission went to U.S. District Court and applied for an order freezing the payments to Yuen and Leung under Section 1103 of Sarbanes-Oxley. The law allows the SEC to petition a federal court to escrow payments when, during the course of an investigation of possible securities violations, it is “likely” that the company will make “extraordinary payments” to officers, directors or certain other individuals.
Scenario ‘Not Business As Usual’
In upholding the trial judge’s decision to grant the SEC’s request for an escrow order, the 9th Circuit said that the judge “correctly focused on the nature, purpose, and circumstances of the payments and determined that they had nothing to do with Gemstar’s ordinary business.”
The court used “as a measure what ordinarily goes on in the process of the issuer’s business,” and concluded that the facts resulting in the severance payments were “clearly unusual and extraordinary.”
The payments, the court said, “are five and six times greater than Yuen’s and Leung’s base salary, the component amounts that make up the
lump sum payments are different than the amounts due under their employment agreements, the termination fees are different from what they may have been entitled to under existing agreements, the bonuses appear to be fruit of the alleged fraudulent financial results, and the vacation pay item did not exist under their contracts. One would not expect benefits like these to be flowing from corporate assets to executives resigning
under fire from key management positions. This scenario is not business as usual. Telling also is the glaring fact that CEO Yuen would not discuss these matters with the Commission, choosing instead to assert his Fifth Amendment privilege.”
One judge dissented from the decision to read the SEC’s power to freeze payments broadly. “Section 1103 empowers the SEC to escrow ‘extraordinary payments,’ not payments made under extraordinary circumstances, particularly where ‘extraordinary circumstances’ means little if anything more than that the company is under investigation for securities violations,” the judge wrote.
But SEC Associate Counsel Humes said the dissenting judge’s view would cause there to be extensive hearings before an escrow order could ever be issued, which is not consistent with Congress’ intent. “You shouldn’t be bogged down with a mini-trial just to get an escrow,” he said, noting that the escrow period is limited and essentially gives the Commission 90 days to complete its investigation.
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